Consumer Staples Hold Up in the Kitchen

With the U.S. economy mired in the longest recession in two generations, we thought we'd turn our attention to consumer staples stocks--a defensive area that should be holding up relatively well. We recently discussed consumer staples stocks with Erin Swanson and Philip Gorham, two of Morningstar's consumer analysts.

Haywood Kelly: Erin, everyone thinks of consumer staples and packaged food stocks as defensive. Have they lived up to that reputation during this recession?

Erin Swanson: Yes, the defensive nature of these firms is shining through, as the sector outperformed the market by 7% and 22% in 2007 and 2008, respectively. Operating fundamentals justified this outperformance, as revenue and profitability at consumer staples and packaged food companies have held up much better than most industries. That said, with the economic outlook improving, the market is gaining ground, exceeding the consumers products' sector return by 10% year to date.

HK: Which of the companies you follow are performing best in this environment? Are any gaining market share?

ES: As consumers eat more meals at home, packaged food companies have been the primary beneficiary. While packaged food firms have seen some pressure on their branded offerings from private-label competition, retailers are still dependent on brands to drive traffic in their stores. Accordingly, dominant branded players have held their own in this market, while second- and third- tier brands have struggled with retailers looking to consolidate vendors and reduce the number of brands on their shelves. General Mills GIS and Unilever UL are doing especially well due to their solid portfolio of leading brands.

HK: Philip, what about the beverage companies you cover--is the recession having any meaningful impact on their businesses?

Philip Gorham: Yes. Everybody needs to quench their thirst, but the recession is affecting the frequency and the location at which consumers are buying soft drinks. Consumers have cut back on their purchases of single-serve bottles at convenience stores, and they are looking to get more for their money in other channels such as grocery stores, where they can buy in bulk. This trend has been accelerated by consumers' increased tendency to cook at home, as Erin mentioned. In response, beverage manufacturers are offering smaller and cheaper single-serve bottles in order to entice consumers at convenience stores.

We've also noticed an abrupt halt in the growth of some categories that could be considered "luxury" products, such as energy drinks and bottled water, as consumers have been switching to cheaper alternatives. For example, tap water increased its share of all drinks consumed in the United States by almost 2 percentage points in 2008, while the share of bottled water declined by 1 percentage point.

HK: How much are consumers trading down to private-label products?

PG: With the exception of bottled water, where store-brand drinks have gained some traction, consumers have not switched to cheaper soft drink alternatives, and the market share of private-label has remained flat at around 10%. We think that there are two reasons for that: Customers are very loyal to their favorite beverage brands, and the leading manufacturers of branded drinks are adept at managing the price gap between their products and private-label alternatives in a way that dissuades the customer from trading down.

ES: Branded packaged foods haven't fared as well. Consumers are increasingly opting for private-label alternatives rather than branded goods, primarily due to the fact that private-label products cost on average 30% less than branded products. Furthermore, around one quarter of all food and beverages served in American homes last year were store brands (up from 18% in 1999). The categories with the highest private-label share, such as eggs, cheese, and oil, are all commodity categories. However, as the perception of the quality of private-label products has improved, the shift from branded goods has become more pronounced. We believe that it will take several years for consumers who traded down to lower- priced private-label alternatives to trade back up to branded offerings.PAGEBREAK

HK: Commodity costs have been volatile recently. What is your outlook for input costs and how will consumer staples deal with elevated prices?

PG: In general, commodity costs are not as high as they were at the height of the economic cycle, but we expect broad commodity inflation to recur when global demand recovers. There are signs that some prices are rising already. For instance, there is a drought in India that is causing the price of sugar, a key input for beverage manufacturers, to spike. Plastic and fuel costs are rising, so packaging and distribution is becoming increasingly expensive, weighing on the profitability of firms with their own distribution infrastructure. We also expect other key inputs such as corn to become more expensive. So overall, we expect raw-material costs to remain a challenge for consumer staples firms. The companies with strong bargaining power, generally those with economic moats, cope with higher commodity costs by raising prices to their customers. For example, Coca-Cola KO and PepsiCo PEP--both wide-moat companies--have pricing power in most markets and are able to pass on input cost increases to their bottlers.

HK: Looking out beyond the current recession, how much growth do you expect from this industry?

PG: In general, we expect the growth potential of consumer staples firms to be hindered by the lack of growth potential in mature markets. However, those firms with significant exposure to emerging markets should have more opportunity to benefit from rising per capita consumption. Philip Morris International PM is an example: We expect the firm to achieve mid-single-digit revenue growth. It operates in key emerging markets in Eastern Europe and Asia, and its product portfolio is well-positioned to exploit consumers' taste for premium cigarettes in emerging markets.

HK: Let's talk about valuations. Looking across the consumer staples sector, is the team seeing many bargains? Are you generally more or less bullish than the market?

ES: There are fewer bargains than earlier in the year in the packaged food space, as the market has recently taken the sector up following solid earnings from several competitors. That said, we still see some good buys. For example, we see value in Kellogg's shares, given its leading position in the domestic cereal segment and its intense focus on reducing costs.

PG: After the market rally, beverage companies' stocks are about fairly valued. However, in the tobacco space, Altria MO appears cheap, as we suspect the market may be exaggerating the potential negative impact from the bill that gave the FDA regulatory control of the tobacco industry. We think that tighter marketing restrictions will be great for Altria, whose dominant market share should now be set in stone. Although the shares have risen slightly above our Consider Buying price, we still see some upside potential, and its dividend yield is 8%.

HK: Which consumer staples stocks are your team most excited about?

ES: We see value in owning Procter & Gamble PG. In our opinion, at 14 times forward earnings, the market is overly discounting head winds such as soft consumer spending and unfavorable currency fluctuation into P&G's shares. However, we believe that P&G knows the consumer, and with brand offerings from value- to premium-priced, we think the firm is well positioned to hold market share in its categories. The company has also learned its lessons from previous downturns when it wasn't as defensive on market share and dialed back on new product innovation. Moreover, P&G has the opportunity to grow revenue and improve profitability in emerging markets where it is still underpenetrated. We expect these factors to lead to higher earnings, and thus, a higher stock price in the future.

PG: Although we'd like to buy the stock at a slightly lower level than its current valuation, we think PepsiCo's move to acquire its North American anchor bottlers could give the firm a competitive advantage in the distribution of niche noncarbonated drinks. We think the market is underestimating how much flexibility this strategy will give Pepsi in its route to market. Pepsi is not simply a beverages firm. With around 60% of its revenues coming from snacks in 2008, its diverse revenue base has held up relatively well during this recession and should continue to hold the firm in good stead over the long run.

Haywood Kelly, CFA, is vice president of equity research at Morningstar.